Compare a loan: How to compare loans and select the cheapest
Tom Kelly
Borrowing money is an essential part of good business. There is a huge range of borrowing options open to people. Banks and financial institutions are more than willing to offer you choices of what way to borrow. There are also some options like leasing and hire purchase which may offer some tax advantages. As a borrower it is not easy to know which borrowing option costs you less and is most efficient. Borrowers need to be cautious as the loan that looks the cheapest may not always be the lowest cost.
If the farmer is trying to compare loans he will look at a number of things:
- The total amount paid back v’s total amount borrowed. This is in effect the total interest paid or cost of the loan. The lower the better generally, not always.
- The interest rate – this will generally be the annual interest rate applicable at the time the loan is being taken out, it may be variable or fixed. Obviously the lower the better.
- The APR rate (annualized percentage rate) this is the rate calculated from the interest applied monthly over the amount of the loan and the interest on the investment accumulated for the year. Again the lower the APR the better.
All three of the above can be used to compare loans, however there are often in-built costs which are not just interest payments e.g. loan insurance, end of lease buy-out and balloon payments, etc. These need to be separated out in order to compare loans.
There are also variations as some loans have the first repayment up front and some have the first payment deferred. Some loans have un-equal repayments, irregular repayments and in these cases it can be hard to get the real cost.
In recent years borrowing capital has been relatively cheap while saving capital has given relatively poor returns against inflation. So anyone putting money into savings is only getting 1% to 2.5% return on capital while inflation is at 3% to 5%. This erosion of the buying power of money is penalising the saver so it has made sense to invest savings and even borrow to invest in appreciating assets and or assets that give you annual cash returns ahead of inflation.
At the same time the difference between loan interest rates and inflation have been narrow, this has reduced the cost of borrowing, particularly for assets that were giving good cash returns or appreciating faster than inflation e.g. property up to 2005, shares since 2006.
The lesson learned here is that the real cost of borrowing is less than the interest rate due to the effects of inflation on the real value of money over time.
So if you were to really compare loans on an equal footing you should adjust for inflation as this is helping you pay for the investment as clearly the € you pay back in future years is worth less than the one you borrowed to-day.
If we take an example of a farmer wishing to borrow €50,000 over 4 years for a new tractor, the farmer gets three or four prices for the loan or lease how can he differentiate which loan offers the best deal. Even if the term of the loans are similar, the no of repayments and the amount of the repayments it may still be difficult to determine the best value.
| A | B | C | D | E | |
|---|---|---|---|---|---|
| Amount borrowed | €50,000 | €50,000 | €50,000 | €50,000 | €50,000 |
| Period | 4 years | 4 years | 4 years | 4 years | 4 years |
| Repayment | €1,185.75 | €1,100 | €7,150 | €1,185.75 | €1,100 |
| No. of repayments | 48 | 48 | 8 | 48 | 48 |
| APR | 6.31% | 7.78% | 6.18% | 6.59% | 6.29% |
| Effective annual rate | 6.50% | 8.06% | 6.38% | 6.79% | 6.47% |
| 1st payment at start of period | 0 | €5,000 | 0 | €1,185.75 | €1,100 |
| 1st payment of end of period | €1,185.75 | €1,100 | €7,100 | 0 | 0 |
| Buy out payment at end | €0 | €0 | €0 | €0 | €4,400 |
| Total payment | €56,916 | €56,700 | €57,200 | €56,916 | €57,200 |
| Interest paid | €6,916 | €6,700 | €7,200 | €6,916 | €7,200 |
| Inflation estimated | 3.5% | 3.5% | 3.5% | 3.5% | 3.5% |
| Discounted value of re-payments @3.5%pa | €53,098 | €53,300 | €52,981 | €53,251 | €53,093 |
| Real cost of loan (*assuming inflation rate of 3.5%) | €3,098 | €3,300 | €2,981 | €3,251 | €3,093 |
The table above shows how confusing it can be to get a good deal. The examples A to E are based on a 4 year loan of €50,000. The loan options offered by lenders and without all the details they can be confusing and misleading and therefore must be looked at with caution.
The real cost of borrowing is the ultimate way of looking at borrowing if you select realistic figures for the erosion of the value of the money you borrowed.
Options A and D offer the same repayment per month except that with A payments start at the end of the first month whereas with D they start at the beginning of the first month. There is no difference in the total interest paid but there is a difference of €153 in the real present day cost if these two loans, this is confirmed by calculation of the interest effective rate and APR.
Option B has a big up front payment and lower monthly repayments but charges a high interest rate and has a high real cost.
C has repayment every six months and offers the best real value for money in this case, as the interest rates calculated are also lowest.
E has lower monthly repayments of €1,100 and a balloon payment of €4,400 at the end, this is the highest in terms of total interest paid but is second best in terms of real cost.
It can be seen from the above that it is important to be able to establish the real cost of borrowed money in deciding you financing options.
Teagasc clients log in here and examine how much your loans are really costing. Basically once you know the repayments and the amount borrowed you can compare the cost of money at to-day’s values over the loan period.